Recently
issued final regulations on partnership
debt-for-equity exchanges contain a
liquidation value safe-harbor method for
valuing the partnership interest
received in exchange for the
cancellation of debt.

Under the
liquidation value safe harbor, the value
of the partnership interest is the
amount of cash that the creditor would
receive if the partnership sold all of
its assets for cash equal to their fair
market values immediately after the
creditor received the interest and then
liquidated.

Commentators have criticized the
regulations, noting that they require
partnerships to recognize COD income
in a debt-for-equity exchange, while
not allowing the creditor to recognize
a bad debt expense.

An
increasing number of businesses are finding it
difficult to pay their debt obligations as a
result of tight credit and a slow economy. In many
cases, businesses are reducing debt by issuing
ownership interests in the entities. Since 1993,
when the Omnibus Budget Reconciliation Act1 was enacted, the tax
consequences for the issuance of corporate
interests in exchange for debt have been clear.
Cancellation of debt (COD) income results when the
fair value of the corporate interest is less than
the value of the debt.2 Such clarity did not exist
for partnerships.

In the American Jobs Creation Act of 2004,3 Congress applied the corporate rule to
partnerships by amending Sec. 108(e)(8). After
Oct. 21, 2004, a partnership recognizes COD
income when the value of partnership equity it
transfers in a debt-for-equity exchange is less
than the value of the debt it receives from the
lender. But the 2004 statute left many questions
unanswered. For example, how should partnerships
determine the fair market value (FMV) of
partnership interests issued to creditors?
Instead of hiring appraisers to determine FMV,
could partnerships use liquidation value? Could
taxpayers recognize any losses upon the exchange
of a debt interest for the partnership interest?
What tax treatment would result when partnership
interests are issued partly in exchange for
accrued ordinary income items, such as unpaid
interest, rent, or royalty income?

In 2008, the IRS issued proposed regulations
under Secs. 108(e)(8) and 721, whereby COD
income must be recognized whenever a partnership
interest is issued in exchange for a debt
interest at a discount.4 In an effort to provide guidance for
taxpayers, the proposed regulations introduced a
“liquidation value safe harbor.” Under this safe
harbor, the FMV of the debt-for-equity interest
will be deemed to be the liquidation value if
(1) the debtor partnership determines its
partners’ capital accounts under Regs. Sec.
1.704-1(b)(2)(iv); (2) the creditor, debtor
partnership, and its partners treat the
indebtedness’s FMV as being equal to the
liquidation value of the debt-for-equity
interest for purposes of determining the tax
consequences of the debt-for-equity exchange;
(3) the debt-for-equity exchange is an
arm’s-length transaction; and (4) subsequent to
the debt-for-equity exchange, neither the
partnership redeems nor any person related to
the partnership purchases the debt-for-equity
interest as part of a plan at the time of the
debt-for-equity exchange that has as a principal
purpose the partnership’s avoidance of COD income.5

The IRS finalized the Sec. 108(e)(8)
regulations on Nov. 11, 2011.6 The final regulations define the
“liquidation value” of a partnership interest as
the amount of cash that the creditor would
receive if the partnership sold all of its
assets for cash equal to their FMVs immediately
after the creditor received the interest and
then liquidated.7

A close inspection of these
rules suggests that taxpayers are still largely on
their own in coming up with the actual fair market
or cash value of their assets to determine
liquidation value. This article assists the
practitioner by analyzing the definition of
liquidation value in the literature on valuation.
This article also addresses the part of the final
regulations that forbids creditors from taking a
bad debt deduction when they accept partnership
interests in exchange for debt.

It is
difficult for taxpayers to accept tax rules that
require the recognition of ordinary income by a
partnership on the one hand yet deny a
corresponding ordinary tax deduction for the
creditor. Accordingly, this article addresses the
detrimental effect of tax rules that taxpayers
perceive as unfair and/or overly complex. Finally,
a detailed consideration of the remaining
provisions in the final regulations is also
included.

Basic Rules

The Sec. 108(e)(8) final regulations state
that when a party transfers its creditor
position to the debtor partnership in exchange
for an equity interest, there is generally no
gain or loss to the partnership, except that the
partnership realizes cancellation of
indebtedness (COD) income equal to the
difference between the debt and the value of the
interest received.8 Moreover, the Sec. 721 approach is
maintained whereby a debt-for-equity exchange
may not be bifurcated to allow the creditor to
recognize a loss or bad debt deduction as part
of the exchange.9

Creditors Denied Bad Debt
Deduction

The final debt-for-equity
regulations under Secs. 108(e)(8) and 721 also
incorporate the interest-first ordering rules,
which require that any payment received in a debt
workout be applied first against interest and then
to principal.10 This result seems
especially unfair when an accrual-based creditor
accrues interest income and pays the related tax.
Upon a subsequent debt-for-equity exchange at a
discount, not only does the creditor fail to
receive the interest income from the partnership,
but he or she also is denied a bad debt deduction.
The bifurcation of the debt-for-equity exchange
would address this concern. In recognition of the
changing ownership interest from debt to equity,
the creditor should be able to take a bad debt
deduction when the value of the ownership interest
is less than the debt obligation.

A
majority of people who commented on the proposed
regulations spoke in favor of bifurcating the
debt-for-equity exchange in cases where the FMV of
the partnership interest is less than the debt obligation.11 They argued that a bad
debt deduction should be allowed for the
difference between the FMV of the equity interest
and the value of the debt obligation. The balance
of the exchange could then be treated as a
nontaxable exchange under Sec. 721. Similarly, in
its comments on the proposed regulations, the
AICPA questioned whether it was appropriate to
deny the creditor an ordinary Sec. 166 bad debt
deduction in such transactions.12 The AICPA also pointed
out how this treatment creates distortions for
partnerships that do not exist for corporations.
Although the IRS received many comments advocating
bifurcation, it explicitly rejected this approach
in the final regulations.13

The following
example from the AICPA’s comment letter on the
regulations illustrates how a debt-for-equity
exchange results in a higher outside than inside
basis both before and after a creditor’s interest
is liquidated. This outcome is a direct result of
the creditor’s not being able to take a current
bad debt deduction.

Example 1. Discrepancy with outside and
inside basis:Suppose nonpartner
individual A converts her $100x loan to the
partnership into partnership equity worth $60x.
Assume at the time of the conversion, individuals
B and C are partners and the
partnership’s tax basis in its assets is $120x
(which also equals B and C’s
combined outside basis).

When A’s
$100x loan is converted into equity, B and
C would have COD income of $40x.
Accordingly, their outside basis would be
increased by $40x and decreased by the $100x of
debt extinguished under Sec. 752(b). As a result,
B and C would have a combined
outside tax basis of $60x ($120x + $40x
− $100x). A would have an
outside basis in her partnership interest of $100x.14 After the conversion, the
final result would be a total outside basis of
$160x in the partnership and an inside basis of
$120x.

If A’s interest is later
liquidated for $60x, she would claim a $40x
capital loss. Next, assuming a Sec. 754 election
was in effect and the mandatory basis adjustment
rules apply, the partnership would have to reduce
the inside basis of its assets by $40x. This $40x
adjustment would reduce the inside basis of the
assets to $20x.15 The partners’ combined
outside basis would be $60x.

Practitioners have observed that the new
rules prevent cash-basis taxpayers from
converting ordinary income into capital gain
upon contribution of unpaid interest and debt to
the partnership in exchange for equity.16 The problem is the way this objective is
accomplished. The final regulations stipulate
that the equity interest received by the
creditor satisfies the interest obligation
first. The balance of the equity interest
satisfies the debt obligation.17

Example 2. Unpaid interest (cash-basis
creditor): Assume A and B form partnership P, each contributing $500. P later receives a $1,000 interest-only note
from creditor C, who is a cash-basis taxpayer. P uses this note and its equity to purchase a
$2,000 asset. At the end of the year, the asset
decreases in value to $800. In addition, assume C has $200 of accrued, unpaid interest. P then issues C an interest in P worth $800 to satisfy the indebtedness.
Under the regulations, the first $200 of the P interest received by C would be deemed to satisfy the $200 of
accrued, unpaid interest. C would recognize $200 of ordinary income. P is deemed to have satisfied the remaining
$1,000 of debt with the remaining $600 of P interest. P would recognize COD income of $400. C would be left with an outside basis in P of $1,200 ($1,000 carryover basis from the
note, plus $200 basis from the accrued
interest).

Once again, if the remaining value of the
partnership interest is less than the
outstanding debt obligation, the taxpayer does
not receive a bad debt deduction. Instead, the
basis of the debt obligation is increased by
interest income recognized by the creditor and
carries over into the new basis of the
partnership equity interest.18

Example 3. Basis of debt carries over to
equity interest: In year 1, I
and T each contribute $500 cash to form the
IT partnership. IT purchased some
computers for $5,000 to use in the new web design
business. The partnership financed the purchase of
the computers with $500 of the equity and a note
from R, the lender, for the remaining
$4,500. At the end of year 3, IT desired to
reduce its debt exposure and issued a partnership
interest to the lender worth $4,000 in exchange
for the note and outstanding interest. Assume that
R was an accrual-basis taxpayer and had
already accrued $600 of interest income at the end
of year 3. The result is that the first $600 in
value of the equity interest will be allocated
toward the outstanding interest and create taxable
income for R. The remaining $3,400 is
applied to the debt obligation. This would also
produce $1,100 ($4,500 − $3,400) in
COD income for the existing partners, I and
T. The new basis of R’s partnership
interest would be $5,100 ($4,500 carryover basis
from debt obligation + $600 of interest).

Example 4. Unpaid interest (accrual-basis
creditor):If C were an accrual-method taxpayer and had
already recognized the interest income, the
result of the transaction in Example 2 would be
the same. The first $200 of the P equity interest C received would be deemed to satisfy the
$200 of accrued, unpaid interest. Already having
recognized $200 of ordinary income, C would not recognize this amount again. P would be deemed to have satisfied the
remaining $1,000 of debt with the remaining $600
of P equity interest. P would recognize COD income of $400. Once
again, C would be left with an outside basis in P of $1,200 ($1,000 carryover basis from the
note, plus $200 basis from the accrued
interest). The fact that C is an accrual-basis taxpayer only creates a
timing difference for the recognition of the
interest income by C.

Denial of Bad Debt
Deduction Viewed as Unfair

An example of a
common principle of fairness in the Code is where
creditors recognize losses or bad debt expenses
when debtors recognize COD income.19 Both the proposed and
final regulations under Sec. 108(e) failed to
provide taxpayers with this traditional symmetry.
Instead, creditors that contribute their debt are
entitled to a carryover basis of their debt
interest, even after recognizing ordinary income
on interest receivable as part of the
exchange.

This denial of a loss and bad debt
deduction is viewed as even more unfair when an
accrual-basis taxpayer is forced to recognize
taxable income that he or she may never receive.
This example illustrates a problem with the Sec.
108(e)(8) regulations in that they do not follow
the matching principle that usually applies in the
Code.

Matching Principle in the
Code

Various commentators explain how the
matching principle is often used to test whether
an accounting method clearly reflects income.20 For example, Sec. 267(a)(2) requires
matching in cases where related taxpayers use
different accounting methods. More specifically,
one taxpayer may not take a deduction for an
expense until the related taxpayer recognizes
the corresponding income. Another example where
the deduction of an expense is denied until the
corresponding income is recognized is Sec.
404(d), under which payments of deferred
compensation to independent contractors may not
be deducted until the year when the contractors
recognize the income.

A third example is Sec. 274(e)(2), which now
requires that items be included in income before
payments for entertainment expenses for goods,
services, or facilities provided to officers,
directors, or 10%-or-greater owners may be
deducted. One final example where the Code
adopted the matching principle is Sec. 83 and
restricted stock awards.21 The employer may deduct the compensation,
and the employee must recognize the income when
the shares are vested.

Unfair Tax
Rules Can Promote Taxpayer Noncompliance With the
Code

The complexity and perceived unfairness of
tax rules, combined with the frustration of not
receiving expected tax benefits, can motivate
many normally law-abiding citizens to
contemplate noncompliance with tax laws.22 For example, National Taxpayer Advocate
Nina Olson argued for the elimination of “tax
traps” to promote voluntary tax compliance. Tax
traps are anomalous tax rules that seem unfair,
such as those that tax “phantom income” (i.e.,income that the taxpayer did not really
receive, or received and then lost, from an
economic perspective). The denial of the bad
debt loss deduction under the Sec. 108
regulations is a prime example of what Olson
described as a tax trap. Olson also explained
how tax traps can move taxpayers from trying to
comply with the rules into the category of those
looking for ways to avoid their tax
obligations.

Recent reports on tax
compliance propose that changing tax laws to
provide more consistency across tax provisions
would promote increased compliance.23 In the context of
financial derivatives in particular, one prime
example of inconsistency is the tax rule that
inadvertently changes ordinary losses into capital
losses. The co-author of the Sec. 108(e)
regulations indicated that the IRS understood
these objections, but that the COD regulation
project was not the appropriate forum to make
these changes.24 He added that it was an
income tax and accounting issue. In summary,
Congress should avoid the imposition of tax rules
that communicate to taxpayers the impression that
heads means the IRS wins and tails means the
taxpayer loses.

Liquidation Value Safe
Harbor

The IRS normally considers all the
facts and circumstances of a transaction to
determine whether it reflects economic reality and
has a business purpose. However, in certain cases,
the IRS permits a simpler accounting method for
determining the tax effects of a transaction.25 These types of exceptions
are usually called “safe harbors.”

The
proposed and final Sec. 108(e)(8) regulations
include a safe-harbor provision called the
“liquidation value safe harbor” (defined
above).

The intent of the safe-harbor
conditions is to ensure that all parties to the
transaction use an arm’s-length standard to value
the partnership equity interest issued in exchange
for the debt. The premise is that the creditor
would therefore not agree to an artificially
inflated liquidation value that would help the
existing partners avoid COD income. One problem
with this premise is that the creditor does not
have any motivation from a tax perspective to
ensure the agreed-upon liquidation value of the
equity interest is equal to the basis of the debt.
The creditor will receive a carryover debt basis
for the partnership equity interest in any event.
Moreover, the creditor may not be willing to
cooperate after being forced by the new
regulations to recognize income for accrued
interest that he or she does not receive in the
current period.

The practicality of the
liquidation safe-harbor provision has also been
brought into question. For example, one
practitioner noted how easily the arm’s-length
requirement could be brought up during an IRS examination.26 Once an IRS agent
questions the comparability of the terms of the
debt-for-equity transaction in an exchange between
unrelated parties, it immediately becomes a
facts-and-circumstances analysis.

Another
problem is the actual calculation of the
liquidation value for purposes of this safe
harbor. Safe-harbor liquidation value is defined
as the amount of cash the creditor would receive
if the partnership sold all of its assets at their
FMVs immediately after the creditor received the
interest and then liquidated. The regulations do
not provide any further guidance for taxpayers to
compute liquidation value under this definition.
Thus, the regulations can be interpreted to allow
a taxpayer to use any reasonable method of
determining the liquidation value of the business
under the safe harbor, although this issue has yet
to be addressed by the IRS or in the courts. In an
effort to provide taxpayers practical assistance
in the calculation of liquidation value under this
safe harbor, the following section presents three
commonly used approaches to value a business from
the valuation literature.

Common Valuation
Methodologies and Liquidation Value

The three common ways to value a business
are the income, market, and asset approaches.
Different methods are also applied under each approach.27 The presence of certain facts and
circumstances will guide the practitioner in
choosing the appropriate valuation approach and
method.

Income
Approach

The most commonly used valuation approach is
the income approach, which bases the company’s
value on the present value of future earnings.
To use this approach, there must be a history of
positive operating results that are expected to continue.28 Typically, when an income approach is used,
it results in the recognition of goodwill value.
Goodwill value, an intangible asset, is the
company’s value in excess of the fair value of
its net assets.29 For example, assume that the present value
of a company’s future earnings is calculated to
be $100,000 and the fair value of the net assets
is $30,000. Goodwill value would be $70,000, or
the amount that the company’s value exceeded the
fair value of its net assets.

The
use of an income approach based on future earnings
assumes that a company will continue as a going
concern into the foreseeable future. This is
contrary to the premise of liquidation value that
assumes the assets of a company will be liquidated
in the near future and there will be no
recognition of goodwill value. The income
approach, therefore, is not appropriate when there
is a history of volatile or negative earnings, or
the forecast of future earnings is negative. If
marginal earnings are expected, a market or asset
approach must be used.

Market
Approach

The market approach determines a company’s
value by using the sales of the same or similar
companies under the same or similar market
conditions. To use a market approach, there must
be a sufficient number of market transactions to
make a reasonable comparison. The IRS favors
this method because it is based on actual
transactions of similar assets.30

The practical application of
this method can be challenging as it may be
difficult to find companies comparable in size,
structure, product makeup, etc. It can also be
difficult to defend a value based on market
transactions if the value is challenged by the IRS
or in litigation. Each transaction can be
scrutinized and attacked as not being perfectly
comparable to the subject company.

The
market approach may or may not provide evidence of
goodwill value. Although applying the market
approach usually results in the recognition of
goodwill value, in rare cases, the company’s
market value approximates or is less than its
asset value, indicating a lack of goodwill.

Asset Approach

Companies
may also be valued using an asset-based approach,
under which the company is valued based on the
fair value of its underlying net assets. Net
assets are defined as the total assets minus
liabilities. An asset-based approach is
appropriate when the company has significant
tangible assets such as buildings, land,
equipment, or other fixed assets. Real estate
holding companies and asset-holding companies are
usually valued based on an asset approach. Also,
an asset approach is appropriate for companies
that have a volatile earning history or where
future earning capacity is limited.

An
asset-based approach usually results in the lowest
value for a company. If either an income or
market-based approach results in a value below an
asset-based approach, an asset-based approach
would be used to determine value. This implies
that an investor would not sell his or her
interest at a price below what the company’s net
assets (assets minus liabilities) would sell for
at fair value. For example, if the value using the
income approach and market approach resulted in a
company value of $200,000 and the value based on
an asset-based approach was computed to be
$250,000, the assets-based approach would be
selected. In other words, a business owner would
not sell a company holding net assets valued at
$250,000 for $200,000.

Two primary methods
are considered to be asset-based methods: the net
asset value method and the liquidation value
method. Both methods determine the company’s value
based on the value of the underlying assets. The
primary difference is the assumptions made about
the continuation of the business.

Net asset value:The net asset value assumes that the company
will continue to operate in the foreseeable
future and meet future obligations. It assumes
that the assets will be sold in a hypothetical
sale as part of a going concern.31 Going-concern value typically assumes
sufficient time to find a buyer willing to pay
the seller the assets’ fair value, which results
in a value significantly higher than liquidation
value. No pressure or compulsion is assumed on
behalf of the buyer or seller. Since the assets’
book value typically does not represent FMV, it
is not unusual to recognize substantial capital
gains on the company’s fixed assets. This is
particularly true with assets such as land and
buildings that have significantly appreciated
from their book amounts.

Liquidation value:Liquidation value assumes that the business
will not continue in the future, but the assets
will be liquidated over a limited period of
time. With the limited exposure to the market,
the assets are typically sold at a price
significantly less than FMV. Fixed assets often
require a year or more to realize full FMV on
the open market. The lower market price results
from a limited exposure to potential buyers as
well as reduced marketing efforts by the seller.
Liquidation value is typically appropriate when
the company is facing bankruptcy and will not
continue as a going concern. Once the valuation
expert has determined that liquidation value is
the valuation methodology, the expert should
select from one of two premises of value: (1)
orderly liquidation or (2) forced
liquidation.

Orderly
Liquidation

An orderly liquidation assumes
that the assets do not have a full amount of time,
but do have a reasonable amount of time, to be
sold on the open market. It is the value of an
asset sold on a piecemeal basis with reasonable
exposure to the market.32 This usually takes place
within six to nine months.33 To value the assets under
this method, the company must have the ability to
stay in business for the appropriate length of
time. This approach is not appropriate if the
company lacks the funds or ability to stay in
business for at least six months. An orderly
liquidation assumes sufficient time to advertise
and market the sale of the assets to the
appropriate buyers.

Forced
Liquidation

In a forced liquidation, the
seller has limited time to liquidate the assets
and pay off the creditors. This approach is
appropriate when the company lacks the ability to
stay in business long enough to ensure an orderly
liquidation, which results in receiving a reduced
amount for the assets. This type of value is based
on the amount received in a quick sale, such as an
auction or sale on the courthouse steps. Forced
liquidation value can be difficult to estimate
since a number of assumptions must be made and may
vary from one appraiser to the next.

It
should be noted that both an orderly liquidation
and forced liquidation assume a certain amount of
compulsion in the company’s liquidation. However,
in a forced liquidation, the company loses a
significant amount of control in the sale of the
assets. Further, assets in an uncompleted form
such as inventory are considered sold as is, and
not subject to further processing. Again, in a
forced liquidation, the company is assumed to lack
the ability or funds to convert those assets, thus
reducing the company’s overall asset value.

A number of steps are necessary to determine a
company’s value using either of the liquidation
value methods.34 To value a company using
the liquidation method, a balance sheet must be
prepared as close to the valuation date as
possible. If interim statements are necessary,
they must be current and adjusted for accruals and
deferrals such as depreciation and accrued
interest.

After a balance sheet is obtained,
the assets and liabilities must be adjusted to
their liquidation values. The size of the
adjustment is affected by whether an orderly or
forced liquidation is assumed. Again, the
assumption of a forced liquidation usually results
in a lower value of the company assets and thus a
lower overall value.

The appraiser then
determines the amount of proceeds, before taxes
and selling costs, which would be received as the
result of the asset liquidation. The proceeds are
then reduced by the company’s direct and indirect
expenses. The value is then adjusted for any net
income or net loss to date. The estimated
liquidation values of the liabilities are
subtracted from the estimated proceeds to arrive
at an estimated net proceeds amount. This amount
is adjusted for any potential tax liability and
capital gains that exist as a result of income
from operations and the hypothetical liquidation
of the assets (although recognition of a capital
gain is rare using liquidation value). The net
liquidation value should be discounted to present
value if the estimated liquidation time period is
more than 30 days. Finally, the appraiser
determines if any discount should be applied to
the final value, such as a discount to reflect a
minority interest or to reflect a lack of
marketability.

Impact of Valuation Method on
Amount of COD Income Under the Sec. 108(e)(8)
Regs.

The liquidation value safe harbor in
the new regulations allows taxpayers to use an
estimate of the amount of cash that would be
received from the liquidation of a partnership at
fair value. In addition, the regulations stipulate
that the estimate must satisfy the arm’s-length
standard as negotiated between parties with
adverse economic interests. There is also a
prohibition of any subsequent purchase or
disposition of the partnership equity interest by
a related party in an effort to avoid COD income.
However, as shown from the valuation literature,
there is a great deal of latitude on the resulting
estimate of fair value depending on the valuation
method chosen.

The most commonly used
valuation method is the income approach, which
relies on earnings to estimate fair value. In
cases where earnings are volatile, a market-based
approach would be used. Using the market approach
will usually result in higher fair value
estimates. The liquidation value method typically
results in the lowest value of any of the commonly
used valuation methods. Of the two liquidation
methods, the orderly liquidation method is more
commonly used. A general rule of thumb is that an
orderly liquidation will net less than half of
fair value and a forced liquidation will net
one-fourth of fair value.35

Use of liquidation
value can have a significant tax impact on the
amount of COD income that should be recognized
when a partnership equity interest is transferred
to a creditor in exchange for outstanding debt.
Typically, the liquidation value approach is used
when companies are facing liquidation through
bankruptcy or other distressed sales transactions.
More often, practitioners will select either the
income or market approach, which will lead to
higher estimates of value. There is an inverse
relation between the estimate of value for the
equity interest and the amount of COD income
recognized by the existing partners on the
exchange of debt for equity.

Other
Provisions Under 108(e)(8) Regs.

Debt From the Performance of
Services

If the debt arose from the performance of
services, the regulations handle this in the
same manner as if the debt arose from a note.
However, the final regulations warn against
sneaking in disguised payments for services and
getting Sec. 721 nonrecognition treatment. The
regulations state that all facts and
circumstances are considered in determining the
FMV of the partnership interest transferred as
compared with the note’s FMV. If the FMV and
partnership interest differ in value, general
tax principles could apply to alter the tax
treatment to the extent of that difference, and
Sec. 707(a)(2)(A), as it relates to the
treatment of payments to partners for transfers
of property, will be considered if appropriate.36

Installment Obligations

The preamble to the final regulations notes
that proposed regulations under Sec. 453(b) are
forthcoming to determine whether a creditor must
recognize any deferred gain or loss when a
creditor contributes an installment obligation
to the debtor partnership, even if the
transaction otherwise qualifies under Sec. 721.
The regulations note that this treatment would
be consistent with the treatment of a creditor
of a corporation that contributes an installment
obligation to a debtor corporation.37

Example 5. Installment obligation similar to
corporations:Assume P purchases
an asset from C in an installment sale for
$500, $100 owed each year. During year 3, after
P has already paid $200 to C,
P realizes it cannot make these payments
anymore and offers C an interest in
P for $200. C accepts this. If the
proposed regulations under Sec. 453(b) are
consistent with the treatment of a debtor
corporation, then C will recognize $100 of
loss on the disposition of the installment
obligation. C’s outside basis in his
interest in P will be $200. P will
recognize $100 of COD income.

Example 6. Installment obligation differs
from corporations:If the new Sec.
453(b) regulation’s treatment of installment
obligations is different from corporate treatment,
then in the above example C will most
likely not recognize any gain or loss. Instead,
C’s outside basis in his interest in
P will be $300, thus deferring any
potential loss until he disposes of the interest.
P will again recognize $100 of COD
income.

Gain or Loss to
Partnership

Finally, the final regulations make clear
that in a debt-for-equity exchange where the
partnership has not disposed of any of its
assets, the partnership should not be required
to recognize gain or loss on the transfer of a
partnership interest in satisfaction of its
indebtedness for unpaid rent, royalties, or
interest that accrued on or after the beginning
of the creditor’s holding period for the indebtedness.38

Summary

The
tax treatment afforded the creditor in a
debt-for-equity exchange under the new Sec.
108(e)(8) regulations has received widespread
criticism. When the fair value of the equity
interest received by a creditor is less than the
value of the debt interest exchanged, no bad debt
deduction is allowed. Furthermore, when interest
has accrued on the debt instrument prior to the
exchange, the creditor must recognize ordinary
income. The denial of the bad debt deduction along
with the requirement to recognize ordinary income
contravenes the matching principle that is
pervasive throughout the Code. Olson, the national
taxpayer advocate, testified before Congress
recently about the negative compliance effect of
tax rules that are viewed as being unfair or
overly complex. Moreover, she argued that the
existence of tax traps can move taxpayers from
those trying to comply with the rules into the
category of those looking for ways to avoid their
tax obligations. Various commentators have hinted
that the IRS may address this perceived inequity
in upcoming regulation projects. The authors think
this change would improve equity in the Code and
improve taxpayer compliance.

The second
major feature of the new regulations concerning
liquidation value received a more positive
response from commentators and taxpayers. However,
a common sentiment was that the liquidation value
of the interest for purposes of the Sec. 108(e)(8)
safe harbor needed further refinement.39 This article reviewed the
practical calculation of liquidation value from
the valuation literature. Depending on which
approach is used (income, market, or asset), which
method is selected (net asset or liquidation), and
which premise of value is used (orderly
liquidation or forced liquidation), the final
determination of liquidation value can vary
greatly. It is reasonable to assume an orderly
liquidation would take place. Specific industry
and market conditions would guide the practitioner
in choosing the right approach and method to
determine liquidation value. Finally, there is an
inverse relation between the estimate of value for
the equity interest and the amount of COD income
recognized by the existing partners on the
exchange of debt for equity. Those methods or
approaches that value the equity interest higher
will produce smaller amounts of COD income.

Authors’ note: Thanks to Bob Crnkovich for his helpful
remarks regarding this article.

Footnotes

1 Omnibus Budget
Reconciliation Act of 1993, P.L. 103-66.

2 Sec.
108(e)(8).

3 American Jobs
Creation Act of 2004, P.L. 108-357.

4
REG-164370-05.

5 Regs. Sec.
1.108-8(b)(2)(i).

6 T.D. 9557.

7 Regs. Sec.
1.108-8(b)(2)(iii).

8 Regs. Sec.
1.108-8(a).

9 Regs. Sec.
1.721-1(d).

10 This rule is
incorporated through a cross-reference in Regs.
Sec. 1.721-1(d)(3) to Regs. Secs. 1.446-2 and
1.1275-2.

23 White,
Testimony Before the Subcommittee on Government
Organization, Efficiency, and Financial
Management, Committee on Oversight and Government
Reform, “Sources of Noncompliance and Strategies
to Reduce It,” House of Representatives (April 19,
2012).

25 For example, to
eliminate disputes in determining the proper
treatment of expenditures to maintain, replace, or
improve wireless communication network assets, the
IRS created special safe-harbor treatment for
these assets, see Rev Proc. 2011-28, 2011-18
I.R.B. 743.

John McGowan is a
professor in the Department of Accounting
at Saint Louis University in St. Louis.
Troy Luh is an associate professor in the
George Herbert Walker School of Business
and Technology at Webster University in
St. Louis. Douglas Murphy is a J.D.
candidate at Saint Louis University. For
more information about this article,
contact Professor McGowan at mcgowanjr@gmail.com.

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